Saturday, May 15, 2010
7:48:26 PM EDT

EU Stink Spreading

by
Jim Brown

The financial contagion from the EU is spreading faster than the oil slick in the gulf and there is no end in sight.

Market Statistics

The sell off over the last two days was blamed on the possible disintegration of the Eurozone. Reportedly French President Nicolas Sarkozy threatened to pull out of the EU last week if Germany didn't go along with the bailout. There were rumors of other countries threatening to pull out on Friday. These rumors were probably started by currency traders short the euro but the impact on the U.S. market was the same.

I mentioned last week that a market looking for a reason to take profits would always find one. I believe the EU is still the convenient excuse for taking those profits.

The euro fell to a 19 month low on Friday as worries increased that the Eurozone was going to disintegrate. The euro fell to $1.2355 intraday and very close to a four year low. Some analysts believe it could hit $1.17 by summer. Economists claim the rising hostility between the EU countries suggested it was going to be increasingly difficult for the weaker countries to get financing despite the promise of $1 trillion in loan commitments.

The EU contagion is like the Lehman problem. Once banks and brokerages started smelling blood in the market they refused to loan to anyone until they were sure it was safe. That meant Lehman and others could not get funding they needed to stay alive. It took nearly a year before banks started lending to each other again.

In the EU countries borrowed from each other and all have counterparty transactions. As the crisis intensifies the normal borrowing has come to a halt and there are fears of a Lehman like collapse where some country can't get the money it needs to cover maturing debts and operating expenses. This is why the finance ministers put together such a large loan package. They want to prevent any country from being locked out of the financing market. Unfortunately saying you are going to make $1 trillion available is not the same thing as actually making the money available. Several countries are already rumored to be ready to back out of the deal.

Some analysts believe the potential for some of the weaker nations to withdraw from the EU is actually a good thing because the remaining nations would be the strong ones and that would make the euro a stronger currency. Unfortunately the markets are worried about banking exposure to the weaker countries should the EU self-destruct.

U.S. banks with high exposure to the EU are GS, MS, C, BAC and JPM but the majority of that exposure is to Germany and France and not seen as particularly risky.

Deutsche Bank CEO Josef Ackerman said he "doubts Greece will ever be able to repay its debts." Any Greece restructuring would force Germany and France to recapitalize their banks.

Paul Volcker raised doubts over the euro's long-term prospects saying, "You have the great problem of potential disintegration of the euro." Also, "The essential element of discipline in economic policy and in fiscal policy that was hoped for" has not occurred. All 16 of the EU countries are in violation of the Eurozone's economic rules regarding deficit limits of not more than 3%. The average is 6.9%. It is becoming increasingly harder to kick the debt can down the road.

The EU accounts for 15% of U.S. exports. The EU crisis is good for the U.S. in some areas. Home mortgage rates sank to their lowest point since December on the flight to the dollar and the buying of U.S. treasuries. The strong dollar and low oil prices suggests the Fed will see no reason to raise rates any time soon.

Europe was barely growing economically before the Greek crisis started and now the rise in interest rates, slashing of budgets and weak euro is going to plunge Europe back into a recession that could be severe in several countries. That lack of future European growth is weighing on the markets.

Art Cashin said on CNBC late in the day that a rumor was circulating that France's credit rating could be in jeopardy. That accelerated the decline in the euro.

Euro Chart

Dollar Chart

Raghuram Rajan, the former chief economist for the IMF, said the outlook for the global economy is bleak unless major structural changes are made to address a number of structural imbalances. According to Rajan some of those changes include putting a halt to the government handouts to lower income citizens. In the U.S. he said an example would be the health care reform that taxes the rich and gives to the poor. The more the government gives to lower income citizens the more those citizens become dependent on future handouts and entitlements.

The government expenses continue to expand and so does the class getting the handouts. The class that shrinks is those in the higher income levels that are paying the tax bill. Rajan says this trend eventually bankrupts the government and leaves the citizens rioting in the streets because their free ride has been canceled. This is what is happening in Greece today. The government provided more and more perks to the citizens until they could no longer afford to pay for the perks. Strikes are already being scheduled in Spain and Italy in protest of their government's plans to cut the deficit.

Rajan also warned that global government spending to promote growth was a band-aid on the problem. The spending promoted rising deficits until the governments could no longer sell more debt to finance the deficits. Then they follow the path of Greece into a severe recession. There is a long list of countries circling the drain and trying to remain afloat but the Greek problem has focused a blinding light on country finances around the world. Greece was able to lie and hide its finances for several years but today that is becoming progressively harder for others heading down the debt default road.

On the economic front, Friday was a busy day but few were paying attention. The retail sales report for April came in with a +0.4% gain compared to a +1.6% gain in March. While that is a big drop is was twice what analysts expected at +0.2%. March sales were revised higher to +2.1%. Spring brought out the home repair crowd and sales at building materials stores like Home Depot rose +6.9%. That was probably helped by the rush to get houses sold by the April 30th tax credit deadline. There was an appliance purchase incentive in many states. Retail sales were up +8.8% over the same period in 2009.

Consumer Sentiment for May came in weaker than expected at 73.3 compares to estimates at 74.5. This compares to the 72.2 in April. It was a small gain but not nearly as positive as you would have expected given the jump in jobs last month. Nearly all the gain came from the expectations component, which rose from 66.5 to 68.3. The current conditions component only rose +0.1 to 81.1. Consumers in the survey continue to say they are depressed but they are spending more money.

Consumer sentiment has remained range bound since September first registered a number over 73. This was the first increase in three months. The rising gasoline prices are weighing on sentiment with the majority of the nation now paying over $3 per gallon. That will change soon given the collapse in oil prices the last two weeks.

Consumer Sentiment Chart

Industrial production for April rose by +0.8% compared to a +0.1% gain in March. Manufacturing output grew by a brisk +1.0%. The gains came despite a small decline in auto manufacturing. Ex-autos production rose by +1.2% and the biggest monthly increase in nearly five years. Capacity utilization was 71.2%. The low was 65.1% during the recession and the high 79% before the recession.

Inventory restocking has not kept pace with sales and with demand and production both rising last quarter inventories are suddenly very lean. The restocking phase is just getting started and it should continue to add to GDP for the next six months.

Industrial Production Chart

Business inventories rose +0.4% in March for the third monthly gain. Inventories are rising across all three segments of manufacturing, wholesale and retail but they are rising at a very sluggish pace. This is because sales have picked up significantly, which is depleting inventories as they are rebuilt. The inventory to sales ratio has fallen to 1.24 from its high of 1.46 a year ago. The smaller the number the less inventory is on hand.

Next week has several key reports on the calendar. The PPI and CPI will be out on Tue/Wed but unless something changed drastically there is no inflation in sight. Expectations are for a minimal +0.1% rise in each. The Philly Fed survey is out on Thursday for the first of the next round of regional manufacturing reports. The Philly survey tends to forecast the national ISM reports so this one is watched carefully.

The big economic report for the week is the FOMC minutes on Wednesday. This is the minutes of the April meeting and they will be scoured for any clues of a future change in bias. Since the Fed kept the "extended period" language I seriously doubt there will be anything material in the minutes but they could be a market mover if something does appear.

Economic Calendar

Tivo's worst nightmare returned again. Tivo has been fighting a patent battle with Dish over the technology in their DVRs and has won every decision along the way. The battle dates back to 2004 when Tivo sued Dish for patent infringement. Dish lost the case and paid Tivo $104.6 million in damages and was barred from using the technology. During the trial Dish redesigned its DVR software so that according to Dish it did not infringe on Tivo's patents.

District Judge David Folsom disagreed and said Dish violated his permanent injunction and ordered Dish to pay Tivo another $103 million plus interest along with $200 million in contempt sanctions. Dish appealed the ruling and lost the case on March 4th. Dish again appealed the case to the Federal Circuit Court in Washington. The Dish CEO has said more than once he did not expect the court to take the case. Unfortunately for Tivo the appeals court said on Friday it would hear the case.

The acceptance of the case means a reprieve for the 14 million Dish DVR users that Dish was preparing to remotely disable. The odds are slim that Dish will prevail because Tivo has won pretty easily on every prior case. Tivo will probably have to wait another couple years before seeing the money and forcing Dish to either license the 14 million DVRs from Dish or turn them off. Tivo lost -41% on the news.

Tivo Chart

Dish Chart

Cisco (CSCO) continues to be punished for what was perceived as cautious comments from John Chambers on the earnings call. Chambers said the business segment was improving slowly but there was a continued need for caution because U.S. employment data was still weak. Chambers said, "Given all the uncertainties regarding the strength and shape of the recovery, concerns about the recovery possibly slowing and the unknown extent of job creation, we encourage you to wait for additional economic data before becoming too optimistic."

Chambers said that although they had not seen any negatives from the EU debt crisis he would need to keep an eye on the region because it accounts for 20% of Cisco's revenue. This is going to be a problem because the euro has declined -18% since December or the dollar has risen 18% depending on how you look at it. That means any sales in 2010 have an 18% penalty attached in the form of currency translation.

Cisco Chart

Nvidia (NVDA) reported earnings after the close on Thursday that beat the street but forecast that revenue would fall by 3-5% for the current quarter. This implied that sales would be between $950-$970 million. Analysts were expecting $990 million. Nvidia also said inventory rose +17% and that worried analysts. A 17% rise in inventories is huge.

After the weak Nvidia guidance the entire semiconductor sector sold off in sympathy with the SOX dropping -3%. The index was off more than 4% late in the day but a spike at the close narrowed the loss.

Nvidia Chart

Can the Apple Phonegate story get any weirder? Sheriff's documents were unsealed on Friday and this missing iPhone case has got so many turns it is starting to look like a daytime soap opera. Turns out that Apple knew Brian Hogan had the phone almost immediately after he "found" it in the bar. Hogan connected it to his roommate's computer and she freaked. She called Apple and told them who had the phone because she was afraid they would trace it to her computer IP and she did not want to be in the loop.

Gizmodo claimed it paid $5,000 for the phone from Hogan but there are multiple amounts in question up to $10,000 plus a $3,500 bonus if Apple announced the phone to the public before July. Apple CEO Steve Jobs actually called Gizmodo and asked for the phone back. That is a guy who obviously thinks nothing ever happens unless he does it. Evidently he was not happy with the results because Gizmodo was willing to give the phone back but they wanted Apple to admit it was a prototype. Steve did not want any publicity that would make consumers wait for the next announcement rather than buying the current iPhones. When he was thwarted he called the police and went after them on theft of intellectual property, industrial espionage, etc. Hey, lighten up guys. Your employee lost the phone. Be happy you got it back plus a lot of publicity. It will all work out for you in the end. You are making a lot of enemies coming down like storm troopers on the various players in the deal.

Waddell & Reed (WDR) lost -5% on Friday after news broke that they sold 75,000 S&P E-mini futures contracts between 2:32 and 2:51 PM last Thursday. WDR said it sold the futures to hedge against longs held by their clients in mutual funds. The notional value of the futures contracts was $4.2 billion. The futures were sold though Barclays Capital. You may remember that Barclays also handled that $7.5 million option trade where a customer bought 50,000 S&P-500 puts just 20 min before the crash. If you are the trading desk at Barclays and within a 30 min period your customers buy 50,000 puts and sell 75,000 E-Mini contracts I could easily see where Barclays could have pulled the trigger on their own hedging program.

The CME identified Waddell & Reed as one of several large trades but said they "found no evidence of improper trading or erroneous trades by any CME customers." Morgan Stanley ended up with the 75,000 futures contracts and told the CME it did not have any concerns about Waddell's activity because they "would typically use equity index futures to hedge macro market risk associated with the substantial long exposure of its clients."

CME said the S&P E-mini contract normally trades 50,000 contracts per hour. During the flash crash they traded 842,514 contracts in the 20-minute period. Gary Gensler, chairman of the CFTC, said that one firm (WDR) was responsible for 9% of the trades during that 20 min period between 2:32 and 2:51 PM. Gensler said that would be an enormous position to sell in a healthy market but in Thursday's market is probably caused quite a shock.

Last Tuesday I wrote about the trading in the ETFs during the Thursday crash. I used data from several news stories reporting on the crash as input for that article. I referred to ETFs and the NYSE in the commentary. Art Cashin, a 40+ year veteran of the NYSE, sent me an email regarding what he called a "New Urban Myth."

SEC Chair Mary Shapiro pointed out in her testimony that of the 281 symbols with canceled trades 193 were ETFs. She also said 25% of all ETFs experienced price declines of 50% at some point. In the same reporting of the crash the NYSE LRP speed bumps were blamed for the lack of bids during the crash.

Art pointed out that there are no speed bumps on ETFs. In fact, no ETFs are traded on the NYSE floor. Therefore, neither the NYSE nor any of its procedures could have impacted prices for 70% of the canceled trades. The NYSE had no egregious trades to cancel. Art said the urban myth of the LRP triggers causing the flash crash was because some TV pundits keep repeating that contention. Thanks Art for putting an end to that myth for our readers!

Chart of WDR

BP claims they are going to use a "riser insertion device" to capture the oil coming from the broken riser on the ocean floor. Basically this is a smaller pipe that will be inserted into the 21 inch riser along with a plug. The theory is that they can suck up the oil to a waiting tanker without it ever mingling with the seawater and forming the ice crystals. My only question is why didn't they try this three weeks ago? If this fails they have the "top hat" containment device on the bottom next to the broken riser and that will be their next attempt followed by the junk shot of miscellaneous debris into the blow out preventer. They are hoping they can clog the leak at the source.

President Obama, probably believing the leak could be halted this weekend, took one more shot at the oil companies saying he would "not tolerate any more finger pointing" between the companies involved in the accident. He called the Senate testimony a "ridiculous spectacle" that could not have impressed the American people. I don't know what he expected. There was an accident, people died and the cleanup will likely cost over $10 billion. Did he expect all three executives to be whipping out their credit cards and trying to be the first to pay the check? This is a major liability and the company at fault has repeatedly said they would pay for it. Taking political shots at big oil, big banks, big anything is turning into an art form this election year.

Oil prices imploded on the soaring dollar, worries over demand from the EU and China and the rising storage levels at Cushing Oklahoma. Crude traded as low as $70.83 on the June contract, which expires next Thursday. The delivery point for WTI crude futures is Cushing OK and they are running out of storage. As of last week there was 36.224 million barrels of oil in storage at Cushing. Actual operating capacity is thought to be somewhere in the 40 million range. This means there is less than 4 million barrels of spare capacity and futures expire this week. Anyone long oil and looking for a place to store it is in trouble. This means you pass the buck to someone else and sell the oil before next Thursday. It is a game of hot potato and nobody wants to be caught holding next Thursday. Add in the dollar spike and the demand worries and we have a monster buying opportunity.

Crude Oil Chart

Gold came within 30-cents of $1250 on Friday in what can only be described as a flight to quality for those who are extremely worried about the future. If the market top in a commodity is evidenced by an obscene indulgence or excessive news then gold could be there.

Last week the seven star Emirates Palace Hotel in Abu Dhabi installed the ultimate ATM machine in the lobby. This ATM dispenses gold, not cash. The machine tracks the price of gold and dispenses 1, 5 and 10-gram bars as well as gold coins at a price the ATM calculates based on the current gold price. You insert cash or a credit card and it dispenses your choice of gold bar. This is the second one installed. The first was in the Frankfurt airport.

Gold ATM

Chart of Gold

Extreme volatility precedes market turning points. The Dow has traded in a triple digit range for 11 of the last 14 days. That should be a clear example of extreme volatility. The VIX moved over 42 around the flash crash and closed over 31 on Friday.

I have been showing you internals for a couple weeks now showing the sharp increase in volume. Volume declined sharply on Wed/Thr but picked up again on Friday. With fluctuations in the billions of shares this is another evidence of volatility. It is also evidence of a lack of conviction.

Internals Table

Since March 2009 the market had priced in a very strong economic rebound for the U.S., China, Europe and Latin America. The U.S. is recovering but the rebound is only lukewarm. We still have somewhere in the range of 440,000 new jobless claims every week and sentiment is barely improving.

China has just moved into a bear market. The Shanghai Composite has broken below the 200-day average and heading south at a high rate of speed. China has rapidly building inflation and they have moved several times to slow down the rate of lending and put the brakes on their economy. Many analysts believe the Chinese economy was in bubble mode and the bubble is bursting. This is causing analysts to lower their estimates for China's growth and the demand on raw materials and commodities.

Shanghai Chart

You know all about the Eurozone so I won't rehash it here but needless to say the enforced austerity programs that are being enacted are going to push much of the EU back into a recession. The proposed $1 trillion in loans may never happen. There is a huge disagreement among the EU nations and it is far from a done deal.

Debt to GDP in the world's top economies will top 100% in 2014. That is 35% higher than when the financial crisis began according to the IMF. Only 3.5% of the growth in debt was for economic stimulus related to the crisis. Nine percent was added due to lost tax revenue during the crisis. The bills continue even though the income declines. In a recent study by Carmen Reinhart and Ken Rogoff it was found that once a country's debt was in excess of 90% of GDP economic growth slowed to 1.7% or less. This is because of the drain on capital required to pay the interest on the debt.

Writers have been warning for many months in these pages about the coming debt storm and what it would do to the U.S. economy. Now the economic clouds overseas have grown into full-fledged storms themselves and the market is finally paying attention. It took a near default by Greece to force action in Europe and that action has finally awakened investors. It only takes a couple months of daily news items before Americans wake up. We are a very complacent people. A body at rest stays at rest and as long as the market was moving higher everyone was at rest and ignoring the news. Now investors are waking up to the realization that maybe the U.S. can't detach from the rest of the global economy and remain insulated from economic problems abroad.

The Fed has pumped $2T into the economy and they are not going to let it collapse now. The market just has to understand this fact and move on. We have the strongest economy and the strongest entities in the Fed and Treasury to deal with the problems as long as politicians don't interfere. This is not the time when politicians should be attacking major corporations to garner votes. The new financial reform bill has turned into a Frankenstein like jumble of draconian rules and regulations. It may have actually mutated to the point where it won't pass and that would be positive for the markets. The daily update of the new rules has been weighing on the financial sector and the broader market cannot rally without financial support.

The Dow is commonly seen as the indicator of economic health in America. It is the most reported index despite being only 30 stocks. The Dow actually gained +239 points for the week thanks to the +400 point short covering rally on Monday. It is hard to look at a Dow decline on Friday of -163 points and be happy it gained +239 for the week. I heard several people predicting another rebound on Monday but I am not holding my breath.

The Dow rallied back to 10,900 and held those gains on Wednesday and early Thursday but could not break through that level. The bulls tried for nearly all of two days but by Thursday's close they were running for the sidelines again. Initial support at 10,700 failed and the new support target is 10,350. The problem with picking lower support targets is that once a bull market rolls over we never know if it is profit taking or a correction or even the early stages of a new bear market. We have to take each level one week at a time and test them all until something eventually holds.

On the Dow chart we have a clear lower high at that 10,900 level and now we are searching for that new support and hopefully it will appear before we set a lower low. I personally don't think the U.S. markets are in meltdown mode. I believe investors are simply pricing in the new global economy and taking profits off the table before summer vacations and before the tax rates rise at year-end. Unfortunately we have to watch the drama unfold one day at a time and we won't know the answer to this story until it ends.

Dow Chart

The S&P almost did the impossible. It rallied to resistance at 1165-1170 but could not make the break. Like the little train that thought he could the S&P tried but in the end it slid back down into the valley. The S&P closed at 1136 and not too far off from critical support at 1100. I would not be surprised to see that 1100 level tested next week. We are going to be in serious trouble if it fails. SPX 1100 is also the 200-day average. That should be support but a move below 1100 is a mutual fund sell signal and a preview of an ugly summer.

On Friday only 10 stocks in the S&P-500 closed positive.

S&P-500 Chart

The Nasdaq flirted with 2400 on Wed/Thr but could not close the deal. It was rebuffed and sent back to the lowest level for the week on Friday. This is not a good sign. The close at 2346 was the lowest close since the crash and the big cap techs are losing ground rapidly. Priceline has given up -65 points in two weeks. Google has given up 85 points since mid April. BIDU fell from $714 to $74 in one day. Gotcha! There was also a 10:1 stock split on Wednesday. You would think that the opportunity to buy BIDU for $74 would attract some buyers in any market but that has not been the case. Tech was a cemetery of broken dreams last week. The 200-day average is 2215 and it could have a bulls-eye painted on it before the month is out.

Nasdaq Chart

The Russell remains the only hope for the market. The Russell was the only index to post solid gains after the Monday spike. Yes, it did decline sharply on Friday but remains very close to the critical 700 level. It closed on Friday within 4 points of the 50-day average while all the other indexes are much lower.

Personally I would not be buying small caps in this market but somebody did and bought a lot. The Russell was up an astounding +6.3% for the week compared to 2-3% for everything else. I have to admit I am baffled by the strength in the small caps in this market so I would remain cautious. Russell 650 is critical support but the RUT closed at 694. There would have to be a lot of selling to bring the Russell down to where the other indexes closed on Friday.

Russell Chart

In summary, the markets are setting up for a retest of support at lower levels. I warned on Tuesday that I expected the markets to give back their gains. Reportedly there were $4 billion in withdrawals from equity mutual funds for the week ended on Wednesday. Funds were almost fully invested so any redemptions would result in asset sales.

The continued triple digit ranges with a seriously negative Friday simply enforces the volatility hangover from the flash crash. From trader emails I receive there are quite a few scared to go back into the market. Quite a few more have not yet finished grieving from being stopped out for major losses the prior week. Trailing stops 20 points lower were hit in many cases. That results in some serious pain.

While nobody expects a repeat performance it remains a cloud over the market. Extreme drops are remembered much longer than strong spikes. A week from now nobody will remember the +400 point rebound on Monday but they will be talking about the 1,000-point dip for decades to come. The SEC is going to announce some new market wide circuit breakers on Monday but it won't bring back those lost profits.

I would be cautious about new positions and try to enter only at the swing highs and lows. I expect the volatility to continue until traders become numb to the daily news from Europe. Sentiment was badly damaged in the Thursday crash and that suggests the path of least resistance is still down. There is no overriding reason to rush back into the markets. I remain cautious until proven wrong.